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Wednesday, August 31, 2011

How Much Revenue from Limiting Deductibility?

One unattractive aspect of having certain expenditures be deductible in the U.S. tax code is that any deduction is worth more to someone in a higher tax bracket. Thus, when it comes to typical deductions like the mortgage interest deduction, the deduction for state and local taxes, the deduction for charitable contributions, or the deduction for large out-of-pocket health care expenditures, someone in a 35% tax bracket saves 35 cents off their tax bill for each $1 of deductible expense, while someone in a 15% tax bracket saves only 15 cents off their tax bill for each $1 of deductible expense. Of course, the two-third of taxpayers who don't have enough of these specific expenses to make it worthwhile to itemize their deductions just take the standard deduction, and get nothing extra off their tax bill for these expenses.

Proposals are always kicking around to reduce deductibility, by limiting the tax savings from a deductible expense to say, 28% or even 15%. How much revenue might such proposals raise?

What about limiting deductibility to 28%?
Daniel Baneman, Jim Nunns, Jeffrey Rohaly, Eric Toder, Roberton Williams estimate the revenue to be raised from a proposal to limit deductibility to 28% in a recent paper for the Tax Policy Center. They write (footnotes omitted):

"To measure the revenue and distributional implications of these proposals, the analysis considers two baselines: current law and current policy. “Current law” is the standard baseline that official revenue estimators at the Joint Committee on Taxation use to score tax proposals. It assumes that tax law plays out as it is currently written. Most important, that means that the 2001–2010 income and estate tax cuts expire at the end of 2012 and that temporary relief from the alternative minimum tax (AMT) expires at the end of 2011. The “current policy” baseline assumes that Congress permanently extends all provisions in the 2011 tax code (except the 2 percent reduction in Social Security payroll tax) as well as AMT relief, indexed for inflation after 2011. ...

[A] proposal from the Obama Administration ... would limit the benefit of itemized deductions to 28 percent. .. Thus, for example, an additional $100 of itemized deductions would save a taxpayer in the 35 percent bracket only $28 rather than $35. The 28 percent limitation on itemized deductions would raise an estimated $288 billion over the next ten years compared with current law ... Relative to current policy, the proposal would raise $164 billion.

The 5.3 million affected households in the top quintile would see their taxes go up by an average of about $2,900. The average tax increase for the 697,000 affected households in the top 1 percent would be about $13,300. Almost all of the tax increase—99.8 percent—would fall on households in the top quintile of the income distribution—those with cash incomes greater than $111,000. ... The top 1 percent would bear 61 percent and the top 0.1 percent would pay a little more than one-third."

What about limiting deductibility to 15%?
The Congressional Budget Office does a regular report called "Reducing the Deficit: Spending and Revenue Options." In the March 2011 report, Revenues--Option 7 is ""Limit the Tax Benefit of Itemized Deductions to 15 Percent." CBO estimates that this change could raise $1,180 billion over the next 10 years relative to current law, which is roughly four times as much as the 28% limitation would raise. The CBO doesn't do a distributional analysis, but this change would only affect those who already itemize deductions, and would have by far its largest effect on those with higher incomes.

Of course, there are justifications for the existing tax deductions, and reasons and history behind the justifications, and interest groups behind it all. But in a situation where all the meaningful options for long-term deficit reduction are going to be painful in one way or another, limiting deductibility has some advantages. It would raise revenue from those with higher incomes without increasing the marginal income tax rates, or part of the revenue could even be used to reduce the top marginal rates. Limiting deductibility also reduces the role of the federal government in certain aspects of the economy like providing incentives for greater mortgage borrowing. It should be in the mix of possibilities.